Over the past six months, The Toro Company’s shares (currently trading at $71.61) have posted a disappointing 5% loss, well below the S&P 500’s 16.3% gain. This was partly due to its softer quarterly results and may have investors wondering how to approach the situation.
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Why Do We Think The Toro Company Will Underperform?
Despite the more favorable entry price, we're cautious about The Toro Company. Here are three reasons there are better opportunities than TTC and a stock we'd rather own.
1. Long-Term Revenue Growth Disappoints
A company’s long-term performance is an indicator of its overall quality. Any business can put up a good quarter or two, but the best consistently grow over the long haul. Regrettably, The Toro Company’s sales grew at a mediocre 6.7% compounded annual growth rate over the last five years. This was below our standard for the industrials sector.
2. Free Cash Flow Margin Dropping
Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.
As you can see below, The Toro Company’s margin dropped by 5.6 percentage points over the last five years. It may have ticked higher more recently, but shareholders are likely hoping for its margin to at least revert to its historical level. If the longer-term trend returns, it could signal it is in the middle of an investment cycle. The Toro Company’s free cash flow margin for the trailing 12 months was 10.9%.
3. New Investments Fail to Bear Fruit as ROIC Declines
A company’s ROIC, or return on invested capital, shows how much operating profit it makes compared to the money it has raised (debt and equity).
We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. Over the last few years, The Toro Company’s ROIC has unfortunately decreased significantly. We like what management has done in the past, but its declining returns are perhaps a symptom of fewer profitable growth opportunities.
Final Judgment
The Toro Company doesn’t pass our quality test. Following the recent decline, the stock trades at 16× forward P/E (or $71.61 per share). This valuation multiple is fair, but we don’t have much confidence in the company. There are better investments elsewhere. We’d recommend looking at one of our all-time favorite software stocks.
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